Tuesday, April 22, 2008


Joseph Ellis wrote one of my favorite economy/market books, "Ahead of the Curve". In it, he shows that consumer spending is the important leading indicator. Furthermore, consumers tend to spend most of what they make. Americans save little, outside of retirement accounts. Much of what Americans save is the sweat equity they put into their homes, which does not show up in savings.

The good news is that paychecks are rising. This means personal consumption expenditures will rise.

An increase in paychecks is a function of pay per hour and the number of hours worked. It is important to measure the total weekly pay as the number of hours worked tends to jump once an economy starts to recover. Businesses do not like to lay off workers. Instead, it is common to lower a factory schedule from 40 to 36 hours rather than to lay off 10% of the workforce. When you currently hear doomers whine that Americans are "under employed" they are saying that even though the unemployment rate is low, the slack shows up in the number of hours worked. One thing the doomers miss is that the number of hours worked in American has gone down a little simply because Americans are wealthy enough that they prefer not to work so much.

In the 15 days ended April 18, the average paycheck went up 3.1%. NO RECESSION IN THESE NUMBERS!


Stock prices fell in anticipation of the "coming recession". In the past few weeks, stock prices have begun to rebound as more investors look at their own situation and realize they are not in a recession. Take out the real estate markets that overheated and the rest of the country is even enjoying seeing home prices increase. The latest numbers for the Piedmont Triad show that the average home in our market went up 2.1% in value in the past year. Again, NO RECESSION IN THESE NUMBERS.


The major carriers have successful raised fares 9 of the last 13 tries, a total increase of $150 round trip on many flights. The prices on the most competitive routes have hardly budged, which is the reason so many of the small carriers are bankrupt or close to being bankrupt. The individual numbers are interesting.

In the last quarter reported, CAL's fuel cost went up by 364 million dollars. It's profits swung from a gain of 102 million to a loss of 80 million. The total swing was exactly one half of the fuel increase. So, the company made up, $182 million dollars, half of the increase through other savings or through fare increases. However, most of these fare increases did not take effect until late in the quarter or even after the end of the quarter.

In the current quarter, a much higher percentage of the fuel increase will be covered by fare increases. Furthermore, this quarter and the next are normally much more profitable than the other quarters. With 3 billion dollars in the bank, CAL is not at risk of burning off its assets, indeed, the cash in the bank went up by a couple of hundred million even though the accounting profits showed a loss of $80 million.

On the other hand, S&P put CAL and UAUA on its credit watch list. There is the risk that the debt securities of these firms get down graded if one decides to pay to much to buy the other. Of course, while it is possible that UAUA will buy US Airways and that AMR will buy CAL, the more likely event will be that CAL and UAUA agree to a stock swap similar to the structure of the DAL - NWA deal.


Rising payrolls in combination with high fuel prices will lead to continued strong demand for air travel. At the same time, economic growth will flow to ways to avoid excessive fuel costs. In other words, it becomes all the more important to seek out the low cost producer around the globe. It is a mistake to think of high fuel costs as the reason not to produce a product over seas.

Some time ago, I reported some powerful transportation numbers. It is really amazing how little it cost to transport 1,000 pounds of product a mile on a train. Once you get it in your mind that the rail transportation cost is nothing when compared to the production cost savings of the most efficient producer, then it is time to look at the cost of shipping half way around the world. The fuel spent floating a boat is basically zero and once you get that boat moving it cost very little fuel per pound to keep it moving. The cost to move 1,000 pounds of product by boat is a tiny fraction of the cost of transporting that same product by train!

Besides, the cost of transporting fuel to a location can cost almost as much as the cost of transporting the product from a location. In other words, a company making a profitable product before his fuel costs go up needs to find a lower cost way of making the product. Chances are good that his industrial cost of fuel is higher than the transportation cost.

Higher fuel cost may tip a product from the profit to the loss category, such as when a country passes rules that raise the cost of electricity. Jobs will go to the area where the total costs, including the cost of electricity are lowest. The producer is forced to look at alternatives when his cost are too high. He just might discover that his product can be made in China for much less. He might also discover that the bulk shipping cost per unit is lower than his extra manufacturing cost per unit. Upon making such a discovery, chances are good that he finds himself on an airplane headed to China.


Part of the reason the inflation numbers are unusually high right now is because China is standing on the brakes. The bank reserve requirements in China have been moved up to an astounding 16%, forcing a slow down in the velocity of money. Insert the increase into the Fisher GDP equation and we know something has to give. If GDP = M x V = P x Q, then a slowdown in V means without an increase in M the GDP growth must slow. If GDP growth slows, then Q is likely to slow. When a company slows down the amount of production, it slows down the products that have the least demand. Once the company finds itself making only the products that are in highest demand, it discovers it can raise its price and still sell all it is making. For this reason, inflation is a late cycle phenomenon. Once the inflation rate gets bad, it is ironic that the profit rebound is near. Not because profits are high during times of high inflation but because the high inflation is an indication that the cycle is turning.

The above scenario is nothing more than an upside down J-curve effect. In other words, the first move is along the short end of the J. After the initial move, a significant turn is made and the long end of the J is dead ahead. Using profits as the example, profits were under pressure causing the company to cut back on production and thus adding to the pressure on profits. However, once the prices are raised on the remaining production, the profits soar. Once the business starts growing again, the profits continue to increase on the old volume and on the new volumes created.


UAUA was hit hard by fuel prices last quarter. CAL continues to put up better than average numbers because the firm has a younger and more fuel efficient fleet. UAUA, DAL, AMR and NWA are all gradually parking a few of their oldest planes. Like the manufacturer above, these companies are reducing capacity by cutting out the losing options. The remaining flights are in high demand and subject to price increases.

The down stroke of the J curve has proven to be a long one for the airlines. The good news is that once the turn is made, the long end of this J is going to seemingly go on forever.

My friend and fellow expatriate from Merrill Lynch made an excellent point yesterday. He suggested that the world might see the kind of rolling recession that we saw in the late 70's and early 80's. I see this as a strong possibility if you substitute the word slow down for recession. The 50% drop in the China stock market suggest to me that the Chinese economy is going to slow dramatically, just about the time that the US economy is in full recovery. However, a dramatic slowdown in an economy that grew at better than 11% last quarter does not imply negative growth. China could slow to half its previous growth rate and still put pressure on oil demand. Still, a world wide slow down of growth will do wonders for allowing new oil production catch up with new oil demand. The change in the change or second derivative is a highly levered figure.


The timing of the merger request of DAL and NWA could not be much better. The loss of $4 per share by UAUA is enough to scare the pants off those who would argue against mergers. In the past, Eastern Air as a prime example, airline employees over played their hands. The unions had the power to not budge on wage givebacks, mergers or work rule changes. They did not budge and the companies folded up shop. The highest paying jobs were lost when the flights were replaced by deep discounters.

During the latest round, DAL, NWA, UAUA, AMR and CAL employees all took pay cuts to save the companies. The managements of DAL, NWA, CAL and UAUA have all pledged not to ask for additional pay cuts as part of merger transactions. In other words, the best way the unions have of keeping wages up is to offer the airlines a route to higher profitability. DAL pilots have already agreed to more flexible rules in order to make the merger work.


With payroll numbers showing strength, with many a housing market starting to turn up and with the elections near, the airlines must get their deals done as quickly as they can. The next reports from the airlines will be under the pressure of higher fuel prices not fully covered by fare increases. By the next quarter, fares could easily cover. Also, at some point, the fuel bubble will burst. Of course, the bursting of the fuel bubble will be initially reported and perceived as a the negative event of an economy that is really getting bad. The most successful investors buy on bad news!